Why More US Banks Aren't Being Allowed to Fail

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With all the doom and gloom surrounding the banking industry from the toxic assets to the nasty recession, you’d think banks would be failing at a furious pace.

Think again. Since the recession began in January 2008, the FDIC has closed just 39 banks—25 in 2008 and 14 thus far in 2009.

By contrast, more than 1000 institutions were closed during 1988 and 1989 when the savings and loan crisis was at its peak. Another 850-plus failed in the ensuing three years when the S&L crisis intersected with the fairly mild recession of 1990-1991.

In 1933, the government closed all 17,000 of the nation’s banks for a long, bank holiday weekend and some 5,000 never reopened.

If all this doesn’t hold up to logic, then try politics.

“It’s worse than the statistics indicate,” says veteran bank analyst Bert Ely. “One of the problems is how slowly regulators move in dealing with this problem.”

Sure, there more banks in the 1930s and 20 years ago then than the roughly 8,400 of today, but analysts say that still doesn’t explain the huge difference.

“The regulators are behind the curve,” adds Gerald O’Driscoll, a former Federal Reserve official and Citigroup VP, now with the Cato Institute. “The regulators are kind of where they were in the late 1980s. Regulators procrastinated, then acted. Regulators become tough when the politicians decide to bite the bullet.”

Banking experts say there are striking similarities between the current period and that of the late 1980s and early 1990s when the federal government went from insufficient stopgap solutions to the savings and loan crisis to a radical overhaul.

“It took a new administration to say we're not responsible, to say we have a bunch of insolvent savings and loans," says Lawrence White, a saving and loan regulator and former White House economist. “It made it easy for the regulators.”

White points out that it also took a new law, called Firrea, which created sweeping regulatory reform as well as a government entity, a bad bank, the Resolution Trust Corporation, to assume control of the institution’s assets and then sell them back into the private sector.

“In those days we weren’t as lenient,” says George Kaufman, a professor of banking and banking regulation at Loyola University, who consults for the Federal Reserve Bank of Chicago, “I think banks have been well under-capitalized.”

And the longer the government waits to close down troubled banks, the longer it will take to restructure the system, goes the thinking, which will also wind up costing taxpayers more money.

Crisis At The Crossroads

A year and a half into this crisis, analysts say there are signs the government is still in denial about the magnitude of the problem as well as the sweeping, draconian actions needed to attack it. At the same time, they say some officials may be on the verge of a turning point in dealing with the issue.

“Bank restructuring should start with some diagnostic phase, where you triage the winners and losers, put them in buckets, some are worth saving others are not,” says Luc Laeven, a World Bank economist who co-authored a study on banking crises of the last 40 years and the policy responses to them. “The government shouldn't be in the business of trying to save all institutions.”

The Treasury Department’s decision to start using stress tests on the top 20 banks may be a key development in that diagnostic phase.

“The scope of how to do a proper banking resolution is quite well known,” says Johnson. “The knowledge base, the data base is there.”

Though Fed Chairman Ben Bernanke told Congress Tuesday that outcome of the tests is “not going to pass or fail”, analysts say if done properly it will help address the problem of how to price the toxic assets and reassess bank capital capitalization beyond the somewhat un-useful existing metrics. In doing so, it will provide the government with more impeachable results in deciding winners and losers.

“They’re going to establish an analytical basis to determine how much capital to commit to banks and at one point to be able to say, 'enough is enough' and we’re going to take this bank over,'” says Ely, who adds the stress test will “essentially move toward [determining] a liquidation value.”

“There’s this kind of pretense of doing scientific analysis and being impersonal and masking that this is very political," says former Senate Banking Committee chief economist Robert Johnson of the stress tests. ”Shutting them [banks] down is hard to do."

The government used the equivalent of a stress test during in the Great Depression. Those that passed were given the necessary capital in the form of a loan in exchange for preferred stock, which is what the Bush administration decided to do at the urging of Congress.

“If you run it properly, you find out how big the hole is,” says Walker Todd, a former Fed official, lawyer and economic historian.

FDIC Chairman Shelia Bair Tuesday the stress tests needed to be done “before we determine what type of additional capital investments the government may need to make."

Where There's Smoke...

There are signs Congress, at least, is running out of patience with the current approach and is looking for more drastic measures.

Members of the Senate Banking Committee Tuesday peppered Bernanke with questions about the government support, suggesting the government was delaying the inevitable.

“Wouldn’t it be better to close some of those banks rather than continue propping them up?” asked Alabama Sen. Richard Shelby, the ranking Republican on the panel. “Aren’t you sending a message that we’re going keep propping the up?”

Bernanke responded by implicitly referring to the stress tests, saying the “first step is to get clarity, the transparency, “ what he called “the assessment”. The next [step] is the capital.”

The biggest banks “are never going to get to the point where that [insolvency] occurs because you keep injecting capital, “ said Sen. Robert Corker (R-Tenn.).

"There is no commitment by any means to never shut down a big bank, absolutely not, but I do believe that the major banks we have now can be stabilized,” Bernanke added.

Similar thinking got the government into trouble with the S&L debacle, say analysts, when capital injections and regulatory forbearance deepened the crisis.

“We believe the quickest and lowest cost solution to the government is to close down troubled financial institutions, regardless of size, extract the toxic assets and sell the good parts of these financial institutions to private investors as quickly as possible,” the bank analysts team at Friedman Billings & Ramsey’s wrote in a Feb. 23 research note.

FBR says bad assets could be put into a RTC-like entity and estimates the process could take six months to a year for the large institutions to be healthy enough to be sold back to the private sector

They argue concerns about nationalization are misguided because bank debt guarantees, TARP funding and credits wraps, most if not all of which have been used at the biggest problem big banks, Citigroup (NYSE: C) and Bank of America (NYSE: BAC), constitute “soft” nationalization.

Kaufman says Citigroup and Bank of America “technically have failed” already because they needed “government assistance.”

There’s also a growing sense in some quarters of the banking committee that the problem really turns on a few big banks and is not yet industry wide.

“The sentiment is Citigroup has failed, so lets tear down the faced and deal with Citi,’ says Robert C. Schwartz, a partner in the law firm of Smith, Gambrell & Russell, which represents community banks in the Southeast. “It just adds angst and uncertainty into the system.”

Schwartz says the 30-plus community banks his firm represents don’t have a “toxic assets problem” but are worried about what they call the “second wave”, managing a bank through a tough recession.

That’s partly evident in the number of banks classified as problem ones by the FDIC. Troubled assets on their balance sheets rose from $78.3 billion to $115.6 billion in the third quarter of 2008. The number of troubled institutions jumped 38 percent to 117, the most since 1995. Only 14 banks, however, wound up failing in the 1995-1996 period. (Fourth-quarter data is due out Thursday,)

Analysts say small banks, even regional banks, are not the problem or the threat.

“It’s the biggest banks that need the bailout,” says Walker, and those hold the vast majority of the estimated $4.54 trillion in FDIC insured deposits.

Conventional wisdom says these banks are too big to fail, but that’s different than being taken over by the government for a period of time, then sold back to the private sector in whole or in parts.

Analysts say the Obama administration is struggling over how to take more aggressive steps in dealing with the banking industry problems because of vast public outrage over both the bailout efforts to date and excessive executive compensation.

The President appeared to take a first step in his speech to Congress Tuesday night, saying "I know how unpopular it is to be seen as helping banks right now, especially when everyone is suffering in part from their bad decisions...But I also know that in a time of crisis, we cannot afford to govern out of anger, or yield to the politics of the moment. My job - our job - is to solve the problem."

“They know that the clock is running,” says Johnson. “He’s [Obama] got to decide what to do. Not deciding can look powerless.”